A retirement savings plan for your wild side

Of all the approaches to building a retirement portfolio, Lou Reed, God rest his soul, might have liked this one. The approach, referred to as floor-leverage, calls for investing your nest egg in two accounts: one filled with safe investments and the other with walk-on-the-wild-side risky investments.

In one account, you would invest the bulk of your money earmarked for retirement, say 85%, in low-risk-income-generating instruments such as ladders of zero-coupon bonds or annuities, according to “The Floor-Leverage Rule for Retirement,” a paper just published about the approach in the Financial Analysts Journal.

And in the other account, you would invest a small portion of your money, say 15%, in high octane investments such as ETFs or mutual funds that maintain a daily 3× leveraged exposure to equities, according to the co-authors of the paper, Jason Scott, managing director of the Financial Engines’ Retiree Research Center; and John Watson, who is a fellow at Financial Engines and a lecturer in finance at the Stanford Graduate School of Business.

According to Scott and Watson, the floor-leverage approach is a spending and investment strategy designed for retirees who can tolerate investment risk but want sustainable spending.

With this approach, you would use the assets and income in the floor account to fund your desired standard of living. And you would review annually the leveraged account. If the leveraged account exceeds 15% of total wealth, then you would buy additional floor spending with the excess.

Of note, companies such as Barclays, Direxion, iPath, ProShares and PowerShares all offer triple-leveraged ETFs on such indexes as the S&P 500
SPX, -0.55%
Russell 2000 and NASDAQ-100, according to a recent Retirement Income Journal article that featured an interview with Scott.

Now even though this approach uses a leveraged account, according to the FAJ summary, the total portfolio isn't leveraged. The leverage, wrote the FAJ, is used as a tool to manage risk. “Similar to the dynamics of constant proportion portfolio insurance, this strategy sells equities and reduces risk when markets decline,” according to the FAJ.

The authors also found, according to the FAJ, that using leveraged ETFs or mutual funds is a cost-effective, limited-liability approach to implementing this dynamic strategy. Scott told the RIJ that with this strategy the investor outsources the most labor-intensive and complicated part of the strategy. For example, if you invested $15 or your $100 portfolio in one of these leverage funds, the manager would leverage your $15 by shorting $30 worth of bonds and investing $45 in stocks, he told the RIJ.

How to invest the floor

So what should you invest the floor in and how much could you withdraw each year from that account? According to the authors, the investments used for the floor and your spending rates are a matter of personal preference. “A retiree with a preference for sustainable real spending should invest in Treasury Inflation-Protected Securities (TIPS) and expect an initial withdrawal rate near 3%,” according to the FAJ summary. “A retiree with a preference for sustainable nominal spending should invest in government bonds and initially withdraw about 4%.”

But if a retiree decides to buy a late-life annuity, a deferred income annuity that kicks in at say 85, with some of his or her assets then a 5% withdrawal rate is feasible, according to the authors.

Of note, Scott and Watson compared their floor-leverage approach with some popular retirement strategies, such as the 4% rule and the bucket or time segmentation approach, and found that most of those rules are either quantitatively vague or unduly complex. “But the floor-leverage rule, which approximates an optimal investment and spending strategy from the economics literature, strikes a balance between precision and simplicity,” wrote the FAJ.

And though it isn’t optimal, the FAJ said the floor-leverage rule is “a very good approximation to the optimal solution; it has at least a 98% efficiency compared with the theoretical optimal solution.”

Scott and Watson also looked at whether you’d be able to maintain your withdrawal rate over the course of your retirement by using the floor-leverage approach. And what they found, using historical equity returns, was that spending was always sustained, though the spending upside account varied widely with equity returns, according to the FAJ. In fact, after 20 years of retirement, spending for retirees when equities performed well was nearly three times higher than when equities performed poorly, the authors noted.

What’s more, spending tends to ratchet upward nicely until a traumatic market event, the FAJ wrote. Although spending is preserved after the event, there is a lengthy stagnation in the spending rate. For example, the authors noted that the 1970 retiree took a substantial hit to the portfolio during the 1973–74 bear market and then had to wait until 1981 for a spending increase, according to the FAJ’s summary.

Jason Branning of Branning Wealth Management, said pre-retirees should consider the Scott and Watson approach and findings alongside other methodological or heuristic floor/upside or essential vs. discretionary approaches. “Like others, Scott and Watson’s methodological floor-leverage rule seeks to strike a balance between seemingly competing goals—retirement security through a spending floor and the investor’s desire that spending or wealth should grow over time,” Branning said.

Some experts recommend using the floor-leverage strategy

So should you consider this approach?

The short answer, according to Meir Statman, a professor at Santa Clara University and author of “What Investors Really Want,” is yes.

“In a way, it is a very attractive idea,” said Statman. “It really corresponds quite well to behavioral portfolio theory where you have mental accounts, one for not being poor. (The safe account) would provide you with what you consider adequate lifetime income in retirement. And then you would have the (leveraged) account for the need to be rich.”

According to Statman, it makes sense for individuals and advisers to think about their portfolios in the context of mental accounting. “We naturally think about it in terms of what is the goal for that money,” he said.

But what might make this strategy difficult to implement for average investors is the use of leverage, of using 3x ETFs, said Statman. With 3x ETFs, returns and losses are magnified. And when you are on the right side of a trade, things are good. But when you are on the wrong side of a trade, things aren’t so good. For instance, if you had purchased five years ago a 3x ETF that tracks the Standard & Poor’s 500 index, you’d be happy. The Direxion Daily S&P 500 Bull 3X Shares
SPXL, -1.65%
is up 300% over the past five years while the S&P 500 is up around 100%. But if purchased the Direxion Daily S&P 500 Bear 3X Shares
SPXS, +1.73%
you’d be down 100% over the past five years.

“People hate leverage,” said Statman. “And so what people actually do instead of buying an index fund and leveraging that is that they buy individual stocks as lottery tickets. So you can have a lottery ticket in two ways. One is with a well-diversified portfolio that is leveraged and another with a non-diversified portfolio that is not leveraged.”

To be fair, not all experts are fond of using leveraged ETFs or mutual funds when building a retirement-income portfolio. “I will say that 3x ETFs may not achieve the returns expected—they may move in opposite the direction of the market, believe it or not,” said Bill Bengen, author of “Conserving Client Portfolios during Retirement.” “Thus, admitting not having spent a lot of time evaluating (the floor-leverage) strategy, it does not seem appropriate.”

Others share Bengen’s point of view.

“One problem, among many, with the triple-leveraged strategy is that the 3x leveraged portfolio does not deliver 3x the market return,” said Larry Siegel, the research director at the Research Foundation of CFA Institute and senior adviser at Ounavarra Capital. “It’s less, and can be much less, and can even be negative when the market return is positive.”

Siegel gave this example: Take a hypothetical $100 investment in the 3x leveraged fund. Say the market falls 10% on the first day. The portfolio delivers a –30% return so you have $70 left. The next day, the market returns to its original level which means it experiences a +11.11% return. The portfolio delivers a +33.33% return so the $70 now grows to $93.33, not $100. If the market is this volatile (a standard deviation of 10% per day), the erosion of value takes place at 6.67% every two days until you have essentially no money left, while the market itself is unchanged. In practice the market’s volatility is a little less than 1% per day, not 10%, so the erosion is slower.

“Note that it’s possible to take advantage of this mathematical property of leveraged ETFs,” said Siegel. “After the market has fallen 10%, you ‘top up’ by buying $30 more of the 3x leveraged fund. When the market then rises 11.11%, the portfolio grows from $100 to $133.33. You are now beating the market. Your cost basis is $130 but your portfolio value is $133.33, again while the market has gone nowhere. But this takes a lot of trading and a lot of spare cash, and almost nobody does it.”

Branning, for his part, notes that the floor-leverage rule might work in theory but not in reality with real people. “Practically, the model offers a guideline for an investment portfolio, but fails to offer the individual retiree customized applications that are comprehensively informed,” Branning said. “Methodological models must include broader planning frameworks by including balance sheet assets, human capital, or social contract assets. Social Security (and possible pension income) is notably excluded in the Scott and Watson model even though Social Security could account for 40% to 60% of necessary spending.”

According to Branning, pre-retirees and retirees should evaluate whether to use the floor-leverage approach or any other for that matter in the context of a comprehensive retirement plan.

“The floor-leverage approach best applies to the investment construction, but seems detached from a broader, unifying retirement planning framework,” said Branning. “Ultimately, retirees need robustness in framework and empirical methods.”

That may be, but it may also be the case that the floor-leverage approach represents yet one more viable way for retires and pre-retirees to make sure they maintain their standard of living over the course of their retirement.

That may be, but it may also be the case that the floor-leverage approach represents yet another way for retires and pre-retirees to make sure they maintain their standard of living over the course of their retirement.

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